Mexico’s problem could not be solved without a substantial reduction in the country’s budget deficit and in the growth of the monetary base. The problem worsened while Silva Herzog and Gurría were at the Toronto meeting of the IMF. President López Portillo surprised them and everyone else by announcing that Mexico would nationalize its banks to penalize them for paying out foreign exchange. The government had fixed the exchange rate; it penalized the banks for following the policy. López Portillo also announced that he had imposed exchange controls. Capital outflow increased.32 The crisis worsened.
Finally, in December, the new government began serious negotiation. In exchange for IMF-proposed loans, it devalued and accepted the longdelayed austerity program. The resolution that Mexico adopted became the pattern for subsequent defaults. Foreign lending declined after the Mexican crisis, so other countries were unable to service international debts. Brazil, Argentina, Venezuela, much of the rest of Latin America, and parts of Africa had to go to the IMF and agree to austerity programs. This began the period known in Latin America as the lost decade. Economies stagnated or declined. The IMF required the commercial banks to commit to additional lending used mainly to pay the interest to themselves on outstanding debt. The Federal Reserve agreed to not criticize the new loans as imprudent (ibid., 212).
32. I am grateful to Ángel Gurría, vice minister in the Mexican Treasury at the time, for helpful discussion of this period.
The rationale for this policy was to prevent domestic banking failures. Unlike Continental Illinois, regulators did not replace managements, insert capital, and mark the bad debt to market. Instead, the IMF and the banks loaned money to the debtors to pay the interest as it came due. The new loans did not go to the countries; they just increased the countries’ debts. Most calculations at the time showed that few of the debtor countries could expect to increase exports enough to repay the debt. The decline in world commodity prices added to their problem.33
Toyoo Gyohten (Volcker and Gyohten, 1992, 220) reported that the current account deficits of the principal debtors increased from $31 to $49 billion and the ratio of their outstanding debt to their exports rose from 165 to 204 percent.34 The problem worsened. Instead of receiving a net capital inflow, debtors had a net capital outflow that reached $24 billion in 1986. The IMF and central bank program was not helping the debtors to move toward a resolution. For their part, most of the debtor countries were slow to adopt the austerity programs agreed to as part of the IMF program. Tax increases and spending reductions were not politically acceptable in stagnant economies.
The program did not work. As early as May 1984, Volcker told the FOMC that “the biggest sign we have of something not working at the margin . . . is the LDC situation (less developed countries)” (FOMC Minutes, May 21–22, 1984, 27). This was his main reason for opposing an increase in interest rates. Later he added that “the sense of knife’s edge or fragility is going to be with us for a while” (ibid., 37).
There was surprisingly little discussion of the debt problem and the policy of sustaining the banks. Volcker was involved actively but did not say much at the meetings. The other FOMC members left the problem to him.
Volcker recognized by 1985 that the program would not reduce the size of the debt. “It was obvious that the fundamental problems from the borrowers’ perspective had not been resolved and a certain fatigue had set in among the lenders” (Volcker and Gyohten, 1992, 212). The banks received more in interest payments than they lent to the debtors. He recognized that the U.S. banks were less willing, or even unwilling, unlike the Europeans, to increase reserves against the loans. “It was all very frustrating. The logic of the situation seemed to require that the banks at least volunteer some significant concessions on interest rates while building their reserves. But as regulators, we did not feel that we could in effect impose losses on the banks by forcing below-market interest rates or large reserves without jeopardizing their willingness to lend” (ibid., 213).35 Once again, concern for the banks dominated decisions.
33. Volcker testified in February 1983 on the actions necessary for resolution. These included determined action by borrowing countries to reduce budget deficits and inflation and to increase productivity growth, additional loans from foreign banks, and management by the IMF (Volcker papers, Federal Reserve Bank of New York, Box 97649, February 2, 1983, 2–4). Resolution did not come until banks began to write down debt values and the U.S. Treasury agreed to the writedown.
34. U.S. banks held 37 percent of Latin American loans. Other shares were Japan 15 percent, Britain 14, France 10, Germany 9, Canada 8, and Switzerland 3.
Attitudes changed in several ways. James Baker, who became Secretary of the Treasury in President Reagan’s second term, offered a plan that recognized at last that the debt could not be repaid without resuming economic growth in the debtor countries. The Baker plan called for increased lending by the IMF, the development banks, and the commercial banks. It was a start but it did not last as a program. The next important step was a bold move by Citicorp to increase reserves against Citicorp’s holdings by $3 billion. This was, at last, recognition by a major creditor that the debt was not worth its face value, a judgment the market reached much earlier. Following this step, some debt-equity exchanges and other approaches reduced the outstanding debt. Final resolution did not begin until 1989, when officials at the New York Federal Reserve developed plans named for Secretary Nicholas Brady, who replaced Baker at the Treasury. Under the Brady plans, debtor countries issued “Brady bonds,” collateralized debt, to the creditor banks. The bonds could be sold. Each debtor country negotiated when it was ready to agree to an IMF medium-term austerity program. The commercial banks had to agree to reduce the value of their claims but they were not required to make additional loans.36 Over the next few years, the principal debtors made Brady agreements. By the early 1990s, most U.S. banks had finally allocated to reserves 50 to 100 percent of the value of their international debt.
About 50 percent of the creditor banks chose to reduce their claims, mainly by reducing interest rates. Only 10 percent agreed to provide new loans; 40 percent agreed to cancel part of their debt. Governments and multilateral banks provided most of the new loans.
35. In 1983, I wrote that a solution to the debt problem required the acceptance by the creditors of a reduction in their claims just as in a bankruptcy. I tried to explain this to Volcker at the time, but he dismissed it (Meltzer, 1983). I published my proposal in a popular magazine to give it wide circulation.
36. Terence Checki at the New York bank did much of the preparation. The Treasury was not at first agreeable, as I learned when serving as an acting member of the Council of Economic Advisers in 1988. The council’s 1989 report, written only a few months before Brady’s announcement, called for reductions in principal, a watered-down recommendation to satisfy strong resistance from Treasury.
Volcker explained his reluctance to propose debt reductions by commercial banks. “I was concerned that countries that still had adequate means to pay would demand similar treatment” (Volcker and Gyohten, 1992, 217). This does not explain, however, the difference in treatment of domestic and international debt problems.
The Brady plans gradually ended this carryover from the 1970s and the Great Inflation and disinflation. As countries adopted stabilizing economic policies and greater openness, capital returned to the developing countries and investment increased.
Depreciating the Dollar
Appreciation of the dollar exchange was another issue left over from the Great Inflation and disinflation. Chart 9.1 earlier in this chapter shows the sustained appreciation from 1981 to 1985 and the subsequent depreciation of the real exchange rate from 1985 to 1987. Most of these changes mirror changes in the nominal exchange rate. Table 9.3 shows the appreciation from July 1980 to the peak in February 1985 followed by depreciation through July 1985 prior to the Plaza agreement (discussed below). May 1987 is the end of the depreciation.
The table
brings out that for the period as a whole, the weighted average appreciated 13 percent, the mark barely changed, and the yen appreciated 36 percent against the dollar. But the swings within and between periods were large.
Critics of these swings made much of the current account deficit, the low saving rate, the budget deficit, and the dependence on foreign capital to finance investment and the budget deficit. Critics pointed out frequently that the United States was no longer a world creditor. Its net investment position fell from a peak surplus of $392 billion in 1979 to a deficit of $270 billion by the end of the decade. The deficit increased steadily in later years.
During President Reagan’s first term, the Treasury opposed exchange rate intervention. Official rhetoric welcomed appreciation and irritated foreign governments by citing appreciation as evidence of economic strength. Foreigners complained about the budget deficit and the unwillingness or inability to reduce it. Appreciation of the dollar increased foreigners’ exports but it also raised the domestic prices of their imports, including oil and other commodities priced in dollars. West Germany intervened frequently, at times by large amounts, to limit the depreciation of the mark. By 1984, the United States occasionally intervened but by lesser amounts.37
Germany faced two main problems. It announced an annual target for money growth keyed to the inflation rate it wished to maintain. Unsterilized intervention prevented the Bundesbank from reaching its target; it chose to accept more policy flexibility than it wanted. Also, Germany’s exchange rate was a central rate for other European countries. Appreciation or depreciation of the mark-dollar exchange rate increased the difficulty of maintaining relatively stable exchange rates with its partners in western Europe. Dudler (1989) discussed the problems of Bundesbank policy during the period.38 He insisted correctly that the Bundesbank authorities remained unconvinced that mostly sterilized intervention could “exert a lasting impact on the exchange rate or break underlying market trends” (ibid., 11).
On paper, United States international economic policy is mainly a responsibility of the Treasury Department. The Treasury can decide to fix the nominal exchange rate. Short of a decision to do so, the exchange rate is determined in the market in response to current and prospective economic conditions at home and in other principal countries. Federal Reserve policy—misleadingly called domestic policy—is a major factor influencing market views about future economic activity and inflation. The Federal Reserve’s dominant role in setting monetary policy gives it a major influence on the exchange rate. Therefore, Treasury decisions to intervene in the exchange market are usually discussed with the Federal Reserve in advance.
At the start of President Reagan’s second term, his chief of staff, James Baker, and his Secretary of the Treasury, Donald Regan, agreed to change places. Baker did not share Regan’s views about exchange rates. He recognized and wanted to respond to the political pressures from manufacturers, farmers, and especially members of Congress. Exporting manufacturers complained about the value of the dollar that, they said, made it difficult for them to compete. Farmers could see that their products’ prices in dollars were more expensive than foreign competitors’. Members of Congress reflected these complaints and responded by introducing bills to restrict imports and protect domestic markets.39 Japan’s trade surplus was their principal concern.
37. For example, with the dollar at a local peak 3.17 marks per dollar, the Bundesbank sold $450 million and foreign central banks sold $1.5 billion in the last two weeks of September 1984. The Federal Reserve sold $135 million during that period (FOMC Minutes, October 2, 1984, 3). Volcker mentioned that there was informal coordination.
38. Hermann-Joseph Dudler was head of the Bundesbank’s research department during this period.
Volcker did not want to expand. He agreed that dollar appreciation had become a problem. “We could have gone out and eased policy, more than policy already was eased. I didn’t want to do that, because I didn’t think we had won the game yet, expectations were so fragile” (Mehrling, 2007, 183).
By the end of 1984, the United States’ current account deficit— essentially the excess of imports over exports—reached $100 billion. Responding to these pressures and concerns, Baker and his deputy, Richard Darman, began discussions with the Japanese that ended at the Plaza Hotel in New York on September 21, 1984. At first, the discussions focused on both macroeconomic policies and exchange rates, but agreement was difficult to achieve. At the Plaza, five finance ministers and central bank governors agreed to attempt an orderly depreciation of the dollar.40 As Table 9.3 shows, the dollar had depreciated substantially during the first half of 1985, before the agreement. The aim was to coordinate intervention policy and further depreciate the dollar. Volcker said, “The Plaza was basically a Treasury-inspired operation, which I was not terribly keen about” (Mehrling, 2007, 185). He described it as a “get-the-dollar-down operation” (ibid.).
The agreement created excitement in the press and financial markets and its implementation required frequent meetings and official consultations with press attention. Proponents of intervention and currency “zones” were delighted. And at the end of the intervention period, the dollar was lower particularly against the yen. The precise effect of the Plaza agreement and subsequent agreements is difficult to separate from other influences. One reason is that intervention was limited. Also, monetary policy changed in a way consistent with depreciation of the dollar.
Coordinated intervention appeals to many, as it did to Baker.41 The Plaza agreement illustrates some of the problems. First, the Plaza meeting did not agree on changes in fiscal and monetary policies. Although the United States wanted Germany and Japan to increase aggregate demand, and they wanted the United States to reduce its budget deficit, the agreement did nothing of the kind. As in the 1977–78 discussions, Germany especially was unwilling to adopt coordinated macro-policies. The idea of coordinated policies has a superficial appeal that vanishes when a government has to tell its parliament that it wants to increase tax rates or reduce spending to help foreigners. Or, a government is reluctant to ask for more fiscal stimulus and risk inflation to accommodate another country. Germany had finally agreed reluctantly to fiscal stimulus in 1978. They did not believe the coordinated intervention produced the promised results. And they worried about the “clear risk that the authorities could miss their ultimate medium-term objectives for non-inflationary growth” (Dudler, 1989, 9). They remembered that although the July 1978 agreement was advanced as a means of keeping exchange rates stable, by November 1978 the Carter government had to intervene to defend the dollar.
39. Gyohten (Volcker and Gyohten, 1992, 235) claims that Congress had 400 bills to restrict imports or to place surcharges on Japanese exports to the United States. Many of these actions pointed to Japan’s restrictions on imports, including especially beef, tobacco, and rice. The Japanese claimed the problem was the large United States budget deficit. Volcker claimed that Prime Minister Thatcher told President Reagan that he had to do something about the dollar. The pound was close to $1 (Mehrling, 2007, 184).
40. Those of Britain, France, West Germany, Japan, and the United States.
41. Humpage (1991) is an excellent introduction to issues about the effectiveness of sterilized intervention. Balbach (1978) provides a detailed analysis of many alternatives.
Second, within the United States policy coordination often appeared to mean using monetary policy to finance fiscal deficits. Volcker was familiar with the coordination in the 1960s that began the Great Inflation. He did not want to sacrifice Federal Reserve independence to the Treasury and was wary of Treasury efforts to influence monetary policy. He expressed concern about the risk of inflation following rapid depreciation of the dollar.
Third, behind the bold talk about coordinated policy, there was little consensus about the aim of policy and about who would intervene and how much each would spend. The Germans claimed that the problem was mainly a U.S.-Japan problem. Dudler (1989, 11) reports the
internal view. The Bundesbank “was determined, however, to reject binding exchange rate commitments which would have forced major central banks to indefinitely defend narrowly perceived target ranges for the biggest currencies.” It favored inflation control over exchange rate management. The Germans wanted much greater appreciation of the yen than the mark. The United States did not want the agreement to call for depreciation of the dollar, so it referred to appreciation of other currencies. Volcker insisted on inserting “orderly” before “appreciation.” He did not want to commit to a large change (Funabashi, 1989, 15).42 However, a paper circulated at the meeting stated that “a 10 to 12 percent downward adjustment of the dollar from present levels would be manageable over near term” (ibid., 17). It is not clear how those who objected to dollar depreciation could agree to that statement. The depreciation reached these objectives before the end of 1985.43
42. Funabashi was a Japanese journalist who interviewed most of the principals in these agreements.
A History of the Federal Reserve, Volume 2 Page 71
